Hedging is a form of investment made to reduce the risk of unanticipated price changes of an asset. Usually, a hedge entails taking a position opposite to the investment that is being hedged. It is, at times, compared to an insurance policy. When someone buys a house, he would want to protect it from unpredictable situations such as a fire. By taking fire insurance — for which he would pay a premium — he can mitigate the losses he would incur in the fire.
It is important to note that hedging, just as insurance, comes at a price. Investment in hedging leaves proportionately less money to invest in the asset that is being hedged. But still, investors tend to do it to minimise the risk.
Hedging via derivatives
One of the most common methods of hedging is via derivatives. The derivatives such as options, swaps, futures and forward contracts, invariably move in the same direction as the underlying asset. Interestingly, the availability of an array of derivative contracts enables investors to hedge them against almost any kind of investment: stocks, commodities, indices, currencies, bonds or interest rates. The derivatives are believed to be effective hedges against their underlying assets.
Sometimes, investors use derivatives to make a trading strategy wherein loss in investment can be recouped by a gain in a derivative contract. For instance, when Ms A buys 100 shares of ABC at ₹10 per share, she would perhaps hedge her investment by buying a ‘put’ option with a strike price of ₹7 expiring in six months. This will enable her to sell the shares at the reduced rate of ₹7 anytime in the next six months. If she has to pay a premium of Re 1 per share for the option, then ₹100 will be the cost of hedging.
If the share price rises in next six months, she will not exercise her option, but if it falls to ₹3 per share, then she will exercise her option and sell her shares for ₹7 per share, incurring a loss of ₹300 on shares, plus ₹100 on premium, which makes a total of ₹400. But without hedging, the loss would have been much higher at ₹1,000.
So, it is worth remembering that hedging is a strategy that comes at a price, and is meant to prevent, or at least minimise, the losses. Also, hedging is imperfect and despite being based on calculated risks, it might not work.